Statutory Audit of Property, Plant, and Equipment (PPE) in Indian Companies [Company law]

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Introduction

Property, Plant, and Equipment (PPE) are tangible assets that are held for use in the production or supply of goods and services, for rental to others, or for administrative purposes. They are expected to be used during more than one period. PPE typically represents a significant portion of a company’s balance sheet, and the audit of these assets is critical to ensuring that the financial statements present a true and fair view.

Legal Framework

The statutory audit of PPE in India is governed by a robust legal and regulatory framework:

1. Companies Act, 2013:
   • Section 128: This section mandates that every company must maintain proper books of account, which include detailed records of fixed assets, such as PPE.
   • Section 129: It requires the financial statements to be prepared in accordance with the accounting standards prescribed under Section 133 of the Companies Act, 2013, ensuring proper presentation and disclosure of PPE.
   • Schedule II: This provides the framework for the computation of depreciation of tangible assets. The schedule outlines the useful lives of different categories of assets, which companies must follow unless they can justify a different useful life.
   • Section 134: Mandates that the Board of Directors should approve the financial statements, including notes to accounts that should have detailed disclosures about PPE.
2. Indian Accounting Standards (Ind AS):
   • Ind AS 16 – Property, Plant and Equipment: This standard prescribes the accounting treatment for PPE. Key aspects include:
     • Recognition: PPE should be recognized as an asset when it is probable that future economic benefits associated with the asset will flow to the entity, and the cost of the asset can be measured reliably.
     • Measurement: Initially, PPE should be measured at cost. Subsequent to initial recognition, it can be carried at cost less accumulated depreciation and impairment losses or at revalued amounts.
     • Depreciation: Depreciation should be systematically allocated over the asset’s useful life. The method of depreciation should reflect the pattern in which the asset’s future economic benefits are expected to be consumed.
     • Derecognition: An asset should be derecognized when no future economic benefits are expected from its use or disposal.
     • Disclosure: Detailed disclosures regarding the measurement bases used, depreciation methods, and useful lives or depreciation rates should be made.
3. Accounting Standards (AS):
   • AS 10 – Property, Plant, and Equipment: Similar to Ind AS 16, this standard is applicable to companies not covered under Ind AS. It provides guidelines for the accounting and reporting of PPE, including aspects such as capitalization, subsequent measurement, depreciation, and disclosure.
4. Income Tax Act, 1961:
   • Section 32: Governs the calculation and deduction of depreciation for tax purposes. The rates of depreciation under the Income Tax Act may differ from those under the Companies Act, and companies need to maintain separate records for tax and accounting purposes.
   • Block of Assets: For tax purposes, PPE is grouped into blocks, and depreciation is calculated on the written-down value of the block.
5. Institute of Chartered Accountants of India (ICAI) Guidance:
   • Guidance Note on Audit of Property, Plant, and Equipment: Provides auditors with a comprehensive framework for auditing PPE, emphasizing the importance of understanding the entity’s business, assessing the internal controls over PPE, and ensuring proper valuation and disclosure in the financial statements.

Detailed Audit Procedures

1. Understanding the Business and Nature of PPE
   • Gain an understanding of the business, its operations, and the role of PPE in generating revenue.
   • Identify the major categories of PPE and their significance to the business.
2. Review of Internal Controls
   • Evaluate the company’s internal controls over the acquisition, maintenance, and disposal of PPE.
   • Assess whether the controls are designed effectively to prevent and detect errors or fraud.
3. Physical Verification of Assets
   • Conduct physical verification of significant PPE items to ensure their existence and condition.
   • Reconcile the physical verification results with the company’s fixed asset register.
4. Verification of Capitalization
   • Examine supporting documentation for major additions to PPE during the year.
   • Verify that only costs directly attributable to bringing the asset to its working condition for its intended use have been capitalized.
   • Check for any instances of incorrect capitalization of revenue expenses.
5. Depreciation Testing
   • Review the company’s depreciation policy and ensure it complies with Schedule II of the Companies Act, 2013.
   • Recalculate depreciation for a sample of assets to ensure accuracy.
   • Verify that the depreciation method and useful lives of assets are consistent with the company’s accounting policy and industry practices.
6. Impairment Review
   • Assess whether there are any indicators of impairment for PPE.
   • If impairment indicators exist, review the impairment testing conducted by management and ensure it complies with Ind AS 36 – Impairment of Assets.
7. Revaluation of Assets
   • If the company follows the revaluation model, ensure that the revaluations are carried out by qualified and independent valuers.
   • Verify that revaluation gains or losses are properly accounted for in accordance with Ind AS 16 or AS 10.
8. Review of Disposals
   • Verify that disposals of PPE are recorded correctly and that any gains or losses on disposal are accounted for appropriately.
   • Ensure that assets no longer in use or scrapped are removed from the fixed asset register.
9. Examination of Repairs and Maintenance
   • Review expenditure on repairs and maintenance to ensure that costs are correctly classified as either capital or revenue.
   • Verify that significant repairs and maintenance expenses have not been capitalized unless they result in an enhancement of the asset’s performance or extend its useful life.
10. Verification of Leased Assets
    • If the company has leased assets, review the lease agreements to determine whether the leases are operating or finance leases.
    • Ensure that finance leases are capitalized, and operating leases are expensed as per the applicable accounting standards.
11. Disclosure and Presentation
    • Ensure that the disclosures related to PPE in the financial statements are complete and comply with the requirements of Schedule III of the Companies Act, 2013.
    • Verify that the financial statements provide a true and fair view of the company’s PPE, including information on capital commitments, revaluation, and impairment.

Practical Examples

1. Scenario 1: Incorrect Capitalization of Expenses
   • Scenario: The company capitalized routine maintenance costs as part of the PPE.
   • Audit Approach: Review the nature of expenses capitalized, verify the classification against accounting standards, and ensure only capitalizable costs are included.
   • Practical Insight: Ensure that routine maintenance expenses are expensed out in the profit and loss account and not capitalized as part of the PPE.
2. Scenario 2: Misclassification of Leased Assets
   • Scenario: The company has incorrectly classified finance leases as operating leases.
   • Audit Approach: Examine lease agreements, determine the classification based on the substance over form principle, and ensure proper accounting treatment.
   • Practical Insight: Reclassify the leased assets if necessary and ensure compliance with the relevant accounting standards.
3. Scenario 3: Non-compliance with Depreciation Rates
   • Scenario: The company has used a depreciation rate lower than the minimum prescribed under Schedule II of the Companies Act, 2013.
   • Audit Approach: Review the depreciation policy, compare the rates with Schedule II, and ensure compliance or justification for using different rates.
   • Practical Insight: Adjust the depreciation charge if the rates used are not justified, ensuring the financial statements reflect true and fair value.
4. Scenario 4: Impairment Indicators
   • Scenario: The company’s manufacturing unit has been operating below capacity, indicating potential impairment.
   • Audit Approach: Evaluate the impairment testing performed by management, review assumptions, and ensure compliance with Ind AS 36.
   • Practical Insight: Confirm that any impairment loss is recognized, and the carrying amount of the PPE is adjusted accordingly.
5. Scenario 5: Revaluation of Land
   • Scenario: The company revalued its land and recorded a significant upward revaluation.
   • Audit Approach: Review the valuation report by an independent valuer, assess the reasonableness of the assumptions used, and ensure proper accounting of the revaluation surplus.
   • Practical Insight: Verify that the revaluation surplus is correctly reflected in the other comprehensive income and not in the profit and loss account.
6. Scenario 6: Disposal of Assets
   • Scenario: The company sold a piece of machinery and recorded a gain on disposal.
   • Audit Approach: Verify the disposal process, review the sales agreement, and ensure that the gain or loss on disposal is correctly calculated and recorded.
   • Practical Insight: Ensure that the asset is removed from the fixed asset register and any related depreciation is stopped.
7. Scenario 7: Classification of Capital Work in Progress (CWIP)
   • Scenario: The company incorrectly classified completed assets as CWIP.
   • Audit Approach: Review the status of the projects, verify the completion date, and ensure that assets are transferred from CWIP to the appropriate PPE category.
   • Practical Insight: Adjust the classification to reflect the correct status of the assets in the financial statements.
8. Scenario 8: Overstatement of PPE
   • Scenario: The company overstated the value of PPE by not accounting for depreciation on assets held for sale.
   • Audit Approach: Review the fixed asset register, ensure that depreciation is accounted for until the asset is classified as held for sale, and verify the reclassification.
   • Practical Insight: Ensure that PPE is not overstated by accounting for all necessary depreciation and reclassifications.
9. Scenario 9: Incorrect Accounting for Borrowing Costs
   • Scenario: The company capitalized borrowing costs on assets that were not qualifying assets.
   • Audit Approach: Verify the criteria for capitalizing borrowing costs, review the loans and the related assets, and ensure compliance with accounting standards.
   • Practical Insight: Ensure borrowing costs are capitalized only for qualifying assets, and others are expensed in the profit and loss account.
10. Scenario 10: Understated Depreciation Due to Extended Useful Life
    • Scenario: The company extended the useful life of an asset without a valid reason, resulting in understated depreciation.
    • Audit Approach: Assess the justification for changing the useful life, recalculate depreciation, and ensure that the change is disclosed.
    • Practical Insight: Correct the useful life and adjust the depreciation charge to prevent understatement of expenses.

Conclusion

The statutory audit of PPE is a comprehensive process that requires auditors to have a deep understanding of the legal framework, accounting standards, and the specific business environment. By following detailed audit procedures and considering practical examples, auditors can effectively assess the accuracy, completeness, and valuation of PPE, ensuring that the financial statements provide a true and fair view of the company’s financial position.

Author

CA Sourabh Kothari (C.A., B.Com)
He is currently working as Partner – Risk and Transaction advisory with a renowned firm in Jaipur having experience in Internal Audit, IFC Audit, Business consultancy, Due Diligence and Management consultancy.
E-mail: Sourabh.kothari@jainshrimal.in | LinkedIn: Sourabh Kothari

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